09 Mar 2023 529-to-Roth IRA Transfers
If the goal is to save for college, there isn’t a better vehicle than the 529 plan. Because of their unique combination of tax benefits, which vary by state, they can offer a greater after-tax return than a normal brokerage account. How much greater depends on a host of factors, as we’ve written about before, but the benefits are there.
Yet, many parents’ express concerns about their limited use, and rightfully so. Because they were designed with college in mind, the tax benefits that make them attractive are only available when funds are used for “qualified education expenses. ” Used for an expense not on the official IRS list, and withdrawals may be taxed as ordinary income plus a 10% penalty.
To address this concern, the Tax Cut and Jobs Act of 2017 allowed up to $10,000 per year to be used for elementary and high school education. The usefulness of this patch is debatable, but it signaled a willingness by Congress to add flexibility.
More recently, the SECURE ACT 2.0 that passed at the tail-end of 2022 added even more flexibility by allowing for tax-and-penalty-free transfers from 529 accounts to Roth IRAs. Of course, criteria must be met, so let’s take a look at what that criteria is.
The 529 account must have been open for a minimum of 15 years and contributions, plus earnings associated with them, made within the last 5 years cannot be transferred. It’s clear these two restrictions are designed to discourage anyone who might think of opening a 529 account, stuffing a bunch of cash into them, then immediately transferring it all to a Roth IRA. One piece of advice I read suggested opening a 529 and contributing a dollar as soon as your child is born, even if you aren’t sure you’ll ever add more, just to start the 15-year clock. It’s a suggestion worth considering, and you can see from the outset that to take advantage of this rule you need to have planned well in advance.
Funds must go into a Roth IRA in the name of the 529 account beneficiary, and there is a lifetime transfer cap of $35,000 per beneficiary. At least for now, here is where the planning opportunities lie. As you may know, a feature of 529 plans is you are allowed to change the account beneficiary, subject to certain rules. This raises the question: does changing the beneficiary restart the 15-year clock?
For example, what if my daughter, Gwen, graduated college and Emily and I still have $105,000 in her 529 account. Could we, over a period of years, move the lifetime cap of $35,000 to Gwen’s Roth IRA, then change the beneficiary to me, transfer $35,000 to my Roth, change the beneficiary (again) to Emily, and transfer the remaining $35,000 to her Roth? Or would we need to wait 15 years every time the beneficiary changes? As of yet, the IRS has not answered this question and opinions seem split on what they’ll decide.
The beneficiary must have earned income in the year of the transfer, and transfers cannot exceed the annual contribution limit ($6,500 in 2023), reduced by any normal Roth or Traditional IRA contributions. Simply put, the beneficiary must be gainfully employed in order to have funds transferred into their Roth IRA.
Finally, there are income limits that can restrict your ability to contribute to a Roth IRA but these limits do not apply in the case of 529-to-Roth transfers.
Ultimately, we’re encouraged by Congress’ recent actions to expand how 529 accounts can be used and intrigued by the planning opportunities they present.
As always, let us know if you have questions.
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